This is a CU Colorado Springs student blog for the following courses: Intermediate Microeconomics and Austrian Economics.

October 27, 2014

The Difference between the Entrepreneur and the Capitalist and their functions in the maintenance of Consumer Sovereignty

ECON
3160 Life among the Econ Blog 1

The
Difference between the Entrepreneur and the Capitalist and their functions in
the maintenance of Consumer Sovereignty

Gregory
T. Bogosian

In popular parlance the terms “entrepreneur” and
“capitalist” are used interchangeably to refer to the owners of private
for-profit businesses. This often leads to the erroneous impression that the
professional managers are the people who make the real decisions about how the
firm shall be run and the owners are parasites who survive by taking money from
the business without earning it. The neoclassical theory of the firm
exacerbates this impression by assuming that the firm makes decisions as though
it were a living sapient organism of a single mind. Austrian economics distinguishes
between the capitalist and the entrepreneur in a way that dispels this notion.
Austrian economics defines the capitalist as the owner of either financial or
physical capital. Austrian economics defines the entrepreneur as the person who
decides to what purpose the factors of production shall be used. Equivalently
and more to the point, the Austrian school defines the entrepreneur as the
party who decides what factors of production shall be used in what industry.
The terms “capitalist” and “entrepreneur” do not refer to individuals. Rather
they refer to functions served in the economy. The functions of the capitalist
and the functions of the entrepreneur can be served by the same individual
simultaneously. Nevertheless, these functions are normally served by different
people. The person who owns the capital is not necessarily the person who
decides what product the capital will be used to make. The Austrian school
calls the money that capitalists earn interest. In finance the term “interest”
denotes the percentage fee on money loans, but in Austrian economics the
definition of “interest” is broader. In Austrian economics the term “interest”
denotes any money that someone makes by supplying either financial or physical
capital. When someone uses their own capital in a business venture they are
supplying that capital to themselves. So the money they earn is still called
interest. The money that the entrepreneur earns is called profit. Profit in
finance and accounting denotes the difference between a firm’s revenue and that
firm’s cost. In Austrian economics profit denotes any gain financial,
intellectual, spiritual or otherwise. In Austrian economics entrepreneurial
profit denotes the money that the entrepreneur earns by moving factors of
production from relatively less valuable uses to relatively more valuable uses.
In other words, the entrepreneur makes economic gain by redirecting things away
from purposes that the consumer desires less and towards purposes that the consumer
desires more.

The mechanism by which the entrepreneur redirects
resources towards more useful purposes is by purchasing those resources at
prices that one would know are too low if one knew what price the product could
be sold for by the time the inputs were processed into the product.Their profit is the difference between the
current costs of the inputs, or resources, and the future cost of the output,
or product. In both Austrian and Neoclassical economics cost is not the nominal
price of the item that the entrepreneur pays for it. Rather, cost in the
economic sense is opportunity cost, the value of the next best alternative
forgone in pursuing a particular purpose. An entrepreneur earns an economic
profit if their revenue exceeds the opportunity cost of their inputs. They
suffer an economic loss if their revenue is less than the opportunity cost of
their inputs. If their revenue exactly equals the opportunity cost of their
inputs, then they earn an economic profit of zero, neither a profit nor a loss.
Zero economic profit is called a normal profit. Normal profits only occur in
the neoclassical model of perfect competition, never in real life. In real life
economic profits and losses are inevitable because the constant emergence of
new knowledge changes the opportunity cost of every input. If an entrepreneur
is earning an economic profit by using one combination of inputs to produce one
product, and other entrepreneurs are not prohibited from doing the same, then
other entrepreneurs will imitate the methods of the entrepreneur earning the
profit so that they may also gain a share of the profit. This process of
imitation moves resources into the use which earns the economic profit, biding
up the price of the inputs and biding down the price of the output untilthe spread disappears and profit is zero.
Then new information changes the opportunity costs of the various inputs by
alerting another entrepreneur to a new source of economic profit and forcing
all other ends back into economic loss. In this way economic profit drives
entrepreneurs to use every combination of inputs for the purpose that the
consumer values most. The use of every combination of inputs for the use that
the consumer values the most is called consumer sovereignty. The most obvious
criticism of this notion is that it seemingly proves that the entrepreneur is
exploiting the rest of society by acting on relevant knowledge that remains
unknown to all others until after the fact. This is fraud in the same sense
that insider trading on the stock market is fraud. The problem with this
criticism is that even if the entrepreneur had a psychic vision that allowed
them to know exactly what the spread between the inputs and the output would be
by the time the product was brought to market, which does not happen in real
life because there is no such thing as psychic visions, the entrepreneur could
still not share such knowledge with the rest of the world even if they wanted
to do so. There is no way to prove to others that there is a positive spread
between present inputs and future outputs in advance. The only way to know for
certain which uses of which inputs will yield a profit is trial and error. It
cannot be predicted with any certainty whether the spread on the present inputs
and future outputs of any new entrepreneurial venture will prove to be positive
and yield entrepreneurial profits or be negative and yield entrepreneurial
losses.

So what the entrepreneur must do to profit is not fraud
because their decisions are not based on secrets that would make everyone else
deny them that profit if they knew those secrets. Rather, the entrepreneur’s
decisions are based on intuition that can only be shown to be true or false by
acting on that intuition. The obvious criticism of this statement is that it
reduces what the entrepreneur does to gambling in the form of allocating
resources based on guesswork for economic gain. Most of us intuitively want to
say that there is a better way to make decisions that affect the whole of our
society than guesswork. This criticism is more effective than the first
criticism because there is a degree of truth in it. Entrepreneurs do make
decisions despite their inability to predict the outcome of those decisions
with certainty. So entrepreneurial activity is like gambling in that very
important sense. The difference between entrepreneurial activity, as the
Austrian school understands it, and gambling is that entrepreneurial activity
yields information about the preferences and relative priorities of the
consumer that cannot be gained any other way. If the preferences and priorities
of the consumer were already known, then there would be no entrepreneurial
activity because profit would always be zero. Thus there would be no incentive
to be an entrepreneur. The entrepreneur discovers more useful purposes for
society’s existing resources through experimentation, not experimentation in
the sense that it is scientifically rigorous but rather experimentation in the
sense that it discerns the merits of ideas by testing them.

Opportunity cost compels the capitalist to supply capital
to the end that the consumer prefers most of all competing ends in the same way
that it compels entrepreneurs to combine the factors of production to fulfill
the end that the consumer prefers most of all competing ends. The capitalist
earns interest on their capital by supplying it to entrepreneurs who will
devote it to useful purposes and turn a profit. Profits and losses allow the
capitalist to serve as the mechanism of economic Darwinism in which the
capitalist redirects their capital from entrepreneurs who lose money to
entrepreneurs who gain money. This process roots out inept entrepreneurs. Inept
capitalists give their capital to inept entrepreneurs who accidentally wipe out
that capital through their losses. Capitalists and entrepreneurs in cooperating
in pursuit of their own material gain serve as the agents of market place
natural selection in which the inept capitalists and entrepreneurs are rooted
out by the competent capitalists and competent entrepreneurs. This economic
competition ensures that only the most competent capitalists and entrepreneurs
serve the interests of the consumer. The ultimate function of the market is to
show the consumer who is best equipped to serve them. Thus the relevant
question about capital is not whether the pecuniary gain of capital owners is
inherently parasitic because it is not parasitic so long as economic natural
selection persists. Rather, the relevant question about capital is whether
there are enough capitalists and enough entrepreneurs who can communicate with
and do business with each other for capital markets to be sufficiently
competitive. The questions of whether there are any obstacles to the
acquisition and deployment of capital or obstacles to assembling new
combinations of factors of production or devoting existing combinations to new
purposes that prevent capitalists or entrepreneurs from fulfilling their social
function are also critical to the health of any market economy. It is the
answer to these questions that determines whether the forces of the market
continue to compel capitalists and entrepreneurs to serve the interests of the
consumer in their own quests for financial gain.